Entries to Natural Order are dedicated to promoting an open & free society.

Monthly Archives: December 2010

Europe’s experiment with a unified currency has fallen victim to duplicity, cupidity & stupidity. Political ideologues purposefully looked the other way when Greece winked & nodded its way into the euro-zone as part of a scheme to protect & project the European welfare state.

Similarly, member countries were allowed to ignore fiscal probity required by the Stabilization Pact as public-sector debt-to-GDP ratios rose beyond limits required under that treaty.

Now, private banks that systemically engaged in risky bets on sovereign bonds to earn high yields find such deals going sour. In turn, they demand bailouts to contain “contagion” lest other banks fall like dominos.

But banks suffering from ill-advised investing are not innocent victims exposed to a random contagious disorder. Their problems are completely self-inflicted, and problems associated with weakened banks should not be considered contagion, per se.

When investors ignore potential problems with repayment of sovereign bonds, it is because of “moral hazard” created by governments guaranteeing that debt. In the US, such guarantees exist for mortgages and student loans as well as implicit promises to repay debt on state and local governments. With such guarantees are off budget, investors & credit-rating agencies tend to overlook it.

For their part, bank regulators must remove perceptions that sovereign debt is risk-free. In turn, banks ought to hold sufficient capital against losses on sovereign loans or have insurance (e.g., credit default swaps) against their sovereign holdings.

While banks should be held responsible for their own mistakes, taxpayers & voters ought rightly blame regulators & politicians for bad policy choices.

But since the only way to learn from a mistake is to bear the costs of doing so, banks & other investors in sovereign debts must accept the “haircuts” warranted under current conditions.

The Obama administration continues to listen to bad advice on how to set conditions for an economic recovery. It seems likely that there will be a significant increase in the tax burden by allowing the Bush tax cuts expire & the ruinous path of deficit-financed government spending will continue.

While deficit-financed government spending is unlikely to boost economic growth in the short run, higher government debt-to-GDP ratios impose significant long-term drag on the economy. As it is, individuals are likely to spread increases in consumption over many years or anticipate higher future taxes necessary to repay larger public-sector debts. As such, deficit-financed fiscal expansions, whether on shovel-ready physical infrastructure or pork, tend to crowd out the private sector and are unlikely to raise output.

It turns out that spending CUTS are more likely to have beneficial impacts since they reduce deficits and debt-to-GDP ratios. The best historical evidence of this is that government spending after WWII dropped nearly 60%. After that, the US economy went into overdrive with a long-lasting, self-sustaining boom!

Tax cuts are much likelier to increase growth than more government spending. For their part, tax cuts by Reagan in 1981-83 and George W. Bush’s in 2003 that both involved lower marginal tax rates led to higher economic growth.

For their part, best-case, tooth-fairy estimates of government spending multipliers of about 1.5 whereby $1 of new government spending supposedly leads to a rise in GDP of $1.50. (The impact of the current “stimulus” spending contradicts this rosy scenario, as does a considerable amount of theory.)

Meanwhile, estimates for tax-cut multipliers are from 3.0 up to 5.0, suggesting that reducing the tax burden by $1 will boost GDP by $3 to $5. And increasing the tax burden will tend to move GDP down by similar proportions.

For their part, the Obama team seems determined to follow an economic policy mix that is the opposite of what could lead to a sustainable economic recovery.

A better course of action would be to decrease marginal corporate & personal tax rates while phasing down government spending.